Thursday, August 28, 2014

Valeant Pharmaceuticals Part XII: the rolling solvency calculation

I am short Various parts of the Valeant capital structure and long a few thousand put contracts.

This is a bet that is levered to terrible outcomes at Valeant. It is not quite a bet on insolvency - but it is a bet on financial stress.

It is a very non-consensus bet. Valeant is considered extremely profitable. Bill Ackman gave a presentation that explained just how profitable Valeant is compared to average pharmaceutical companies and the numbers are breathtaking.

If Bill Ackman's assertion is correct (and it may be) then my bet is guaranteed to lose money.

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That said the enormous profitability of Valeant is not evident in the audited accounts.

Valeant's audited accounts show large an increasing cumulative losses.

The difference between the GAAP earnings and Valeant's cash earnings estimates are large restructuring and other charges which Valeant management assert are one-off results of acquisitions.

The argument is that if the acquisitions stop these one-off expenses will also stop and so the GAAP earnings will rise to converge with the so-called "cash EPS".

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The problem with this argument is that the one-off costs which are more than 100 percent of profits are not audited in that no auditor asserts that they are truly "one off".

You have to take management's word for it.

Some of these costs I have managed to verify are truly one off. In one instance I have verified the reverse, however that one instance was trivially small.

So you are really left with management's word.

At the end Valeant is a "trust me" story. The sole question is do you trust management and in particular their estimate of non-recurring costs. If you do you see a well run company at ten times earnings.

If you don't trust management then alas the company becomes very hard to value because there is clearly some truth in the management assertion of "one-off costs" and the true underlying earnings are somewhere between GAAP EPS and management's "cash EPS". Alas that is an enormous gap.

If 80 percent of the one-off costs are truly one-off my short is also a bad idea. Valeant would not be trading at ten time true earnings - but it would not be expensive.

For my short to be right I need a substantial proportion of the one-off costs to actually be recurring.

Genuinely this is an assessment I can't make.

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Still against GAAP cash flows Valeant looks insolvent. GAAP cash flow from operations over the past four quarters sums $1.3 billion and net debt is about $16.8 billion. There is also some compulsory capital expenditures which need to be funded out of cash from operations.

Consider this against personal finances: someone with debt more than ten times their cash flow is not obviously refinanceable. A company is more refinanceable than the person because a person needs to hold a fair bit back just to eat. The company can dedicate most of its cash flow to servicing debt. But this is edge-of-refinanceable whatever you want to count.

On the pure GAAP numbers this company looks particularly difficult especially as much of their debt needs to be refinanced starting in 2017.

Linked here is a Google Spreadsheet with the quarterly numbers for Valeant (and legacy Biovail) going back to the March quarter of 2007. The raw numbers come from CapitalIQ. The first three pages of the spreadsheet are my calculations from the raw numbers. [You can reconstruct the data if you wish.]

In this table - from 2011 only - I have listed

(a). the GAAP cash from operations,
(b). the sum of the GAAP cash from ops over the last 4 quarters
(c). the net debt at the end of the quarter
(d). the net debt averaged over the last four quarters

and (e) a calculation of the average debt divided by the cash from operations over the last four quarters.

The last calculation in appropriate for an acquisitive company as it accounts for the rising cash flow given acquisitions.

For the Fiscal Period Ending

Cash from ops

Cash from ops - trailing four quarters

net debt

net debt - averaged last 4 Qs

Average annual debt/cash from ops

3 months

3 months
Q1
Mar-31-2011

86.3

304.8

4,310.3

2,569.7

8.4

Restated
3 months
Q2
Jun-30-2011

190.7

386.5

4,304.9

3,611.9

9.3

3 months
Q3
Sep-30-2011

173.7

449.3

4,969.4

4,194.9

9.3

3 months
Q4
Dec-31-2011

189.8

640.5

6,480.6

5,016.3

7.8

3 months
Q1
Mar-31-2012

167.2

721.4

6,671.9

5,606.7

7.8

3 months
Q2
Jun-30-2012

254.6

785.3

7,161.3

6,320.8

8.0

3 months
Q3
Sep-30-2012

166.8

778.4

7,382.2

6,924.0

8.9

3 months
Q4
Dec-31-2012

67.9

656.6

10,110.1

7,831.4

11.9

Restated
3 months
Q1
Mar-31-2013

255.3

744.6

10,203.4

8,714.2

11.7

Restated
3 months
Q2
Jun-30-2013

305.1

795.1

8,254.7

8,987.6

11.3

3 months
Q3
Sep-30-2013

201.7

830.0

16,808.4

11,344.1

13.7

3 months
Q4
Dec-31-2013

279.9

1,042.0

16,779.4

13,011.5

12.5

3 months
Q1
Mar-31-2014

484.3

1,271.0

16,787.4

14,657.5

11.5

3 months
Q2
Jun-30-2014

376.0

1,341.9

16,763.1

16,784.6

12.5

Note that debt is 12.5 times GAAP cash flow. On the GAAP numbers the company looks extraordinarily difficult.

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It is even worse when you consider the GAAP cash flow has to fund some stay-in-business capital expenditures. Valeant is known for cutting capital expenditures to a minimum so this is not a big consideration but here is another table with the GAAP cash flows less capital expenditure compared to average debt.

For the Fiscal Period Ending

Capital expenditure

Free cash (ie cash from ops less capex)

Free cash, trailing twelve months

net debt - averaged over last 4Qs

Average net debt/cash from ops

3 months

3 months
Q1
Mar-31-2011

(21.5)

64.8

270.1

2,569.7

9.5

Restated
3 months
Q2
Jun-30-2011

(12.5)

178.2

342.2

3,611.9

10.6

3 months
Q3
Sep-30-2011

(9.6)

164.1

396.4

4,194.9

10.6

3 months
Q4
Dec-31-2011

(15.0)

174.8

581.9

5,016.3

8.6

3 months
Q1
Mar-31-2012

(11.1)

156.1

673.2

5,606.7

8.3

3 months
Q2
Jun-30-2012

(13.6)

241.0

736.0

6,320.8

8.6

3 months
Q3
Sep-30-2012

(57.1)

109.7

681.6

6,924.0

10.2

3 months
Q4
Dec-31-2012

(25.9)

42.0

548.9

7,831.4

14.3

Restated
3 months
Q1
Mar-31-2013

(14.0)

241.3

634.0

8,714.2

13.7

Restated
3 months
Q2
Jun-30-2013

(12.8)

292.3

685.3

8,987.6

13.1

3 months
Q3
Sep-30-2013

(24.9)

176.8

752.4

11,344.1

15.1

3 months
Q4
Dec-31-2013

(63.6)

216.3

926.7

13,011.5

14.0

3 months
Q1
Mar-31-2014

(58.1)

426.2

1,111.6

14,657.5

13.2

3 months
Q2
Jun-30-2014

(113.5)

262.5

1,081.8

16,784.6

15.5

On this measure the average debt is now 15.5 times the available cash flows to service it. There is a word for that: stuffed.

In other words if you believe the GAAP numbers this company is so dead it is pushing up daisies.

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The company however should not be dead if what the management says is correct. The management have continuously asserted that there are (literally) billions of dollars of non-recurring costs and that when there are no more acquisitions the operating cash flow will rise by billions of dollars.

If that is the case then the solvency calculations above are entirely moot. All will be well for the company.

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Strangely the solvency measure deteriorated sharply lately - rolling average debt is now 15.5 times trailing twelve month available cash flow - and that is despite it being more than a year since the mega-acquisition of Baush + Lomb closed. The company has done many small deals since - but the plausibility of one-off costs associated with old mega-acquisitions is declining.

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If you believe management vis the one-off costs incurred by Valeant then the solvency measure above - average debt to trailing cash flows - is going to improve dramatically over time.

My plan: to continue updating this post until either (a) the cash flows improve as management guides or (b) the company loses all credibility and maybe dies.

The whole process could take years. I am patient. I hope my clients are too. And as always I could be entirely wrong.

22 comments:

Anonymous
said...

Since we are on the topic of GAAP cash flow, which I believe is the most relevant metric, take a look at how fast their working capital is deteriorating. Even if you add back the cash adjustments they provide in earnings releases, they still aren't generating anywhere near their adjusted income. Also don't forget that if they use cash to take down leverage, their tax rate goes up. Double whammy in the making.

Many companies are able to refinance debts that amount to many multiples of their 'cash flow'. Just look at the finances of publicly traded REITs and MLPs. Also, you're quoting GAAP cash flow from operations, which is net of interest expense. When looking at a company's ability to service its debt, should you not be looking at it on a pre-interest expense basis?

Thanks for all your posts John, always very interesting to read. I agree with your assessment that the crux of the issue is the the validity of management's non-gaap numbers. But therefore, doesn't that mean then that the most important piece of your investment thesis is your insight and assessment of management itself?

(e.g. This suggests to me that the most important questions are in the vein of: Have you had a chance to meet and talk to them? What type of due diligence on management have you been able to do that others have not? What gives you the confidence that they are not being truthful? What do you know about them that the market does not? What is your edge oncoming up with a viewpoint on management? etc.)

As you (and Bronte) are an investor with a real edge at analyzing financials (and imho as a reader, applying a skeptical/pragmatic lens to them that many investors lack...), isn't this type of bet (essentially shorting management's credibility/truthfulness) a bit of a deviation from your circle of competence? Obviously time will tell as to where the GAAP financials end up going (converging w/non-gaap, or not), but it seems at this point you are working less from your normal quantitative position of financial facts, and more from a position of qualitative hope/feeling as it doesn't seem at this point (or at least it hasn't made it to the blog yet) that you have generated a compelling contra-case on the quality of management.

So yeah, I guess the above boils down to "Why are you so confident with your negative bet on management, and what do you know that makes you disagree with the market?

Do you have differentiated information on management? Or is it just that the magnitude of the difference between gaap/non-gaap is so great, that it is just seems very unlikely in your mind that management is being truthful, and therefore seems like a good probability-weighted risk/reward? (but again if that is the case, seems more like a "hope trade" instead of your normal investment...

(not sure if this posted previously or not... please delete if it is a repeat, thanks)

Thanks for all your posts John, always very interesting to read. I agree with your assessment that the crux of the issue is the the validity of management's non-gaap numbers. But therefore, doesn't that mean then that the most important piece of your investment thesis is your insight and assessment of management itself?

(e.g. This suggests to me that the most important questions are in the vein of: Have you had a chance to meet and talk to them? What type of due diligence on management have you been able to do that others have not? What gives you the confidence that they are not being truthful? What do you know about them that the market does not? What is your edge oncoming up with a viewpoint on management? etc.)

As you (and Bronte) are an investor with a real edge at analyzing financials (and imho as a reader, applying a skeptical/pragmatic lens to them that many investors lack...), isn't this type of bet (essentially shorting management's credibility/truthfulness) a bit of a deviation from your circle of competence? Obviously time will tell as to where the GAAP financials end up going (converging w/non-gaap, or not), but it seems at this point you are working less from your normal quantitative position of financial facts, and more from a position of qualitative hope/feeling as it doesn't seem at this point (or at least it hasn't made it to the blog yet) that you have generated a compelling contra-case on the quality of management.

So yeah, I guess the above boils down to "Why are you so confident with your negative bet on management, and what do you know that makes you disagree with the market?

Do you have differentiated information on management? Or is it just that the magnitude of the difference between gaap/non-gaap is so great, that it is just seems very unlikely in your mind that management is being truthful, and therefore seems like a good probability-weighted risk/reward? (but again if that is the case, seems more like a "hope trade" instead of your normal investment...

John, I have been short this POS since late 2012 and have pressed my short on big moves. I think all the famous long term holders will start trimming heavily or blow out prior to years end. The caveat being if VRX gets its hands on a solid balance sheet (AGN) the game can go on a while longer. Too many headwinds they can't control all of which will be a Akman termed "deathblow" -Interest rates, tax rates and good old momentum selling. Keep the faith and remember not even Ackman bought this turd.

The inconsistencies are becoming too obvious to not question management’s trustworthiness. Take their sale of the injectable business for example, at the time of the sale Pearson was quoted saying that they sold it for “more than 5 times sales” . He repeated that comment at a conference held shortly after. 5 times sales implies annual run rate of $280 million for the assets.

In their Q2 release, they reported injectable product sales of $46.8 million for Q2 2014 and $80.5 million for Q2 2013. The 42% drop was due to “confusions” over sale of the business. Let’s just ignore the excuse for the drop and focus on the numbers. The trailing 12mo revenue at the time of the sales was $280 million, and this includes one bad quarter of $46.8 million. So they did about $78 million in each of the other three quarters. Now, the kicker is they are reducing 2014 revenue guidance by $230 million, because supposedly they projected $230 million of sales for these assets in the second half! That’s $460 million of sales a year, or more than 40% growth from its current range! Even giving a lot of credit to their original plan for expanding the sale force, revenue just doesn’t grow that fast. If they did $80.5 million in Q2 2013, but $78 million in each of the 3 quarters after that, sales isn’t growing!

Now, back to the qualitative. Letting your sales drop 42% in a quarter, because you are selling the business? That’s some major bs. Also, if your 5 times sales multiple is based on a trailing 12 month number accounting for the disastrous drop prior to the sale, you can’t exactly brag about getting a good deal for your shareholders, which is what Pearson did.

“By selling it ahead of time we have eliminated one more roadblock in terms of our integration with Allergan and we were able to get a price that was more than five times sales, so we think it also creates real shareholder value,” said Valeant Chief Executive Michael Pearson.

For 2Q14, they excluded the injectable business in their growth calculation. Why would you exclude that, when the sale was completed on July 10th or AFTER the end of 2Q? HA, it's because if you don't exclude it, the actual organic PF growth and same store growth would have been 6% and flat, respectively, compared to the 8% and 4% they reported. And this is on their numbers.

If you read the footnote on their organic growth, it's almost comical. They exclude "assets held for sale". So anytime a business underperforms, cue facial injectables tanking 40%, it gets classified to asset held for sale and becomes excluded from growth calculation. Can't say they are not clever.

How interest is accounted for under GAAP vs IFRS is totally irrelevant. There are simply two questions here:

1. how much levered free cash flow does the business actually generate?

2. does that free cash flow number converge with their adjusted net income, which is supposed to be cash net income?

For VRX, the answer to question 2 is "nowhere close". The funny thing is, that's what the seqoia fund comment was alluding to. They have been bleeding cash in working capital. Seqoia thinks it's due to their expansion in emerging markets; I am much more skeptical. Expansion impact should not be more than a one-year drag, but they are still guiding to a free cash flow number that is substantially lower than their adjusted net income, a full year after the last major acquisition. By the way, you need to compare their adjusted cash flow from op minus capex to adjusted net income, so both are after capex, assuming capex is proxy for depreciation. They judge their cash conversion with adjusted cash flow from op to adjusted net income. That's several hundred million of wiggle room from capex and totally not fair.

Haha, I love how instead of talking numbers and facts, some people just scream "Sequoia"!

Their transcripts are always informative, and I appreciate their effort in making that available to the general investing public. However, even the best investors make mistakes, no matter how researched their trades seemed at the time. In this instance, Sequoia looked at both Valeant and Allergan and took a pass on Allergan, despite admitting that they have fantastic assets. Restasis went on to get a patent that's valid past 2020, and Allergan probably would have been the much better trade from risk/reward perspective.

I don't doubt that Pearson has a list of other companies to buy. The problem is those companies need to have a certain size, enough growth to pull up the overall growth rate of the business, and a clean balance sheet so Valeant can leverage off it for the transaction. Oh, they have to be willing sellers too. No that easy to find companies that fit all those criteria.

I seriously doubt you actually bet on the numbers, John. Looks more like you're betting on a pattern.

When audited GAAP says one thing and management tells different, the history tells us where the statistically clear winning bet is.When management presents a fresh and nice-looking non-GAAP metric to cover for that, well, your statistics on that bet improves further.

Having said that, I'm still a huge fan of disguising a witty combination advertising/factoring business as a "revolutionary model" and selling that to a general investment populace at what again times GAAP earnings? Heck, that wasn't even a fraud in a strict sense. Pure genius. Almost too bad we don't see more of it, all these old tricks of hiding and misrepresenting losses are just so rough in comparison...

Regards,Dmitry.

P.S. Having said all of the above, it also stroke me that a business model in pharma based around cutting down all the way on investments and aquisition focus might look like a reasonable short even without cash flow/potential fraud problems. It's still generally unsustainable and full of legitimate business risks (very few point-and-buy conglomerates ended up as well-integrated, cohesive companies)

The debt numbers are high but not outrageous. At c. 5.0x EBITDA, total leverage is about average for a high yield issuer. Even if you assume Valeant should trade on a 10x EBITDA multiple, that's a 50% debt to EV metric....Free Cash flow (pre interest)/interest on your numbers is about 1.4x (assuming 700m of cash interest - bit higher than 2013), this is also pretty reasonable for a growing high yield company.

All of these are from rough Bloomberg numbers, but I doubt that the Debt markets are going to be a big problem for Valeant.

Sequoia has the same uninformed argument every other bullish investor has and that is Valeant is a great company because R&D is low and expenses are being cut that drag down performance at other pharma that actually invent drugs through research.

Valeant's product is not free and not inexpensive Amortization of intangibles is a reasonable proxy for costs of products and using that added to the R&D gives us a ratio of 27% spending to revenue. Allergan has some of the highest R&D spending and they come in at 17%. Sequoia should know better. Product through acquisition is a real and very high expense.

Also mentioned was 2014 organic growth upstream. It was 4% and that looked pretty good up from 0% for annual 2013. It wasn't. Valeant redefined the criteria for inclusion of acquisition revenue and changed it from 24 months in 2013 to 12 months in 2014. If you use 24 months in 2014, organic growth is negative. That has serious implications. With no big acquisitions, revenue growth and cash flow are going to slow --organic growth isn't sufficient. Pearson has made more than a few bad acquisitions and is reaping the rewards of slow to no growth.

I would like to see how VRX address the following FACTS:As per AGN court filing, VRX calculated B&L’s organic growth for Q1 and Q2 2014 using 2013 B&L revenue that’s $38.1mm lower than the revenue reported in the Oct 18, 2013 8K filing. Notice VRX didn’t address this in their latest rebuttal. I wonder why…

In its Q2 presentation, VRX stated its DSO decreased, but on a closer look, it reclassified $138mm of accounts receivables to Prepaid Expenses and Other Current Assets. In its 2013 10K, accounts receivable and prepaid expenses were $1,815 and $205 respectively. In its Q1 2014 filing, the YE 2013 accounts receivable and prepaid expenses were changed to $1,676 and $343 respectively

Management keeps insisting that without acquisitions, their adjusted and GAAP cash flows should converge. Then why are they guiding to adjusted free cash flow numbers that are 15-20% lower than their own projected cash net income in their standalone case? E.g. 2015 mid-point cash EPS of $9.65 = cash net income of $3.2bn; they are guiding to ~$3bn of adjusted cash flow from operations. But they don’t add back depreciation to cash EPS, so their cash net income should be comped against free cash flow, which is ~$2.75bn. That’s on their own numbers, not even GAAP free cash flow. Anyone’s guess as to how big the gap between GAAP cash flow and cash net income would be.

Why not just do a simple top down estimate to ballpark VRX value...?If you look at another diversified Healthcare company like JNJ, its sells for about 3.5 times sales (Enterprise value, EV). Adding VRX market cap and net Debt gets to an EV of $67bn (at $110/share today). Last Qtr sales annualized is about $11Bn, so it sells for about 6 x sales. The prior $260 / shr price was way overpriced. Assuming same margins as JNJ it looks pricey at $110/shr. It has stronger organic growth products boosted by price increases; pricing won't last and without more acquisitions going forward JNJ probably has a better pipeline since it has spent on R&D. So 6xsales is still too high (higher growth offset by poor pipeline). Price can still go lower to $60 or $70.

Also - check the day it did the B&L acquisition...it added the same amount in market cap that day as it spent on B&L! Was B&L really worth twice as much in VRX hands? Can lower taxrate double net margin, and do it quickly? Whole thing looked like a bubble since it passed $50/share, IMO

Analyzing VRX is an incredible amount of brain damage for too many uncertainties...isn't it better to go long the pharma companies (e.g., AGN, ENDP, etc.) dragged down in sympathy with VRX's "issues" but where they don't have the same exposure? In other words, why not exploit the dislocation without the real unknowable business/fraud risk? VRX is just too binary at this point.

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